Much has been written in the financial press about the massive outperformance of Growth stocks relative to Value stocks over the past several years. Further, many pundits have and continue to warn about a potential Growth to Value rotation or mean reversion trade. The Pier 88 Investment Team will let others speculate as to the duration or demise of Growth’s reign. Instead, we humbly submit that convertible bonds may be an advantageous way to gain exposure to amazing growth companies while offering downside protection should the Value rotation or a market correction occur.
We believe the hybrid nature of a convertible bond provides the dual benefit of equity upside participation while offering some level of downside protection. The bond’s delta is the attribute or characteristic that describes the bond’s sensitivity to the movements of the underlying equity, while the theoretical bond floor and the company’s liquidity position and cash flows provide further insights to the downside protection. A review of three growth stocks and their convertible counterparts is illustrative.
Online market place Etsy has been a very strong performer this year with its stock price up over 200% YTD. Strong business fundamentals have helped fuel investor interest in the name which now trades at approximately 8x Price/Sales. Investors can debate whether that valuation is warranted, but it is not debatable that all growth stocks face the potential risk of multiple contraction. Fortunately, ETSY has several convertible bonds allowing an investor to select the risk profile with which he or she is comfortable. As the chart depicts, convert performance has tracked the stock.
The two older convertibles trade above par while the new issue trades slightly below par. All three convertibles will likely participate in the upside if the equity continues to rally; however, the ’26 and ’27 convertibles offer better protection in a downdraft. The scenarios depicted in the chart below, suggest how each instrument will likely behave given a hypothetical +/- 25% and +/- 50% move in the equity.
|Participation Estimate ETSY 0% 3/1/23||99%||100%||97%||100%|
|Participation Estimate ETSY .125% 10/1/26||68%||80%||65%||85%|
|Participation Estimate ETSY .125% 9/1/27||32%||40%||35%||45%|
Source: Pier 88 Research
As the chart depicts, each convertible presents a different risk/reward profile with the 0% ‘23 issue essentially mirroring the performance of the equity while offering limited downside support while the .125% ’26 and .125% ’27 issues offering varying degrees of upside and downside capture.
Another big winner this year is medical device company DexCom which offers continuous glucose monitoring systems for patients with diabetes. Strong fundamentals have fueled a 90%+ rise in the stock price this year resulting in a valuation of approximately 23x trailing twelve months Price/Sales. Continued earnings beats and raises and momentum could continue to drive the stock; however, a slowdown in the company’s growth rate or market rotation could weigh on shares. DXCM offers two convertibles: a higher delta issue (96 delta) that trades well above par (~$262) while one trades much closer to par (~$107) and has a lower delta (58 delta). Similar to the higher delta ETSY issue above, the high delta convertible mirrors the equity while the other bond has lagged.
That said, the downside protection offered by the lower priced, lower delta convertible is superior. The scenarios depicted in the chart below, suggest how each instrument will likely behave given a hypothetical +/- 25% and +/- 50% move in the equity.
|Participation Estimate DXCM .75% 12/1/23||93%||100%||89%||100%|
|Participation Estimate DXCM .25% 11/15/25||29%||49%||31%||52%|
Source: Pier 88 Research
Finally, telemedicine provider Teladoc Health Inc. has been a huge performer this year as the COVID19 shut down helped spur the adoption of telemedicine as a substitute for in person physician visits. The company has delivered results far surpassing Street expectations and the equity has appreciated over 120% this year and now commands a valuation of approximately 23x trailing twelve months Price/Sales. Moreover, its recent move to acquire high flier Livongo Health Inc. (LVGO) has been controversial and has resulted in increased volatility in the name. Teladoc has several convertible bonds outstanding and we highlight the performance and recent volatility of the equity and the 1.375% ’25 and 1.25% ’27 issues below.
Once again, the hypothetical scenario analysis is illuminating. The higher delta higher dollar priced ’25 issue is essentially a stock call. As TDOC equity does not pay a dividend, the coupon payment of the ’25 bond helps the bond deliver slightly modest upside relative to the stock. Unlike the ’27 issue, the ’25 bond offers no downside support.
|Participation Estimate TDOC 1.375% 5/15/25||97%||101%||96%||101%|
|Participation Estimate TDOC 1.25% 6/1/27||47%||54%||52%||56%|
Source: Pier 88 Research
Our fundamental research suggests strong demand trends and bullish prospects for each of these growth companies. They are innovators which are growing much faster than their core industries as the companies take market share. Investors can debate the valuation levels which these businesses warrant over time. Momentum has likely helped drive the share prices of their equities, and that momentum may continue. The hybrid nature of convertible bond may be a very timely risk management tool for investors wanting exposure to growth assets but are cognizant of relative valuation. As the three above scenarios illustrate, we believe convertible bond issues offer a varying degree of risk/reward and a more thorough analysis is warranted when considering higher octane names.